Buying beyond our means, adjustable rate mortgages, and reverse mortgages are common mortgage mistakes that many consumers make. But even financially savvy Americans can make the wrong choice when it comes to paying mortgage discount points. The decision on whether or not to pay points is not necessarily as simple as many mortgage originators would have homebuyers believe.
In a perfect world...
In general, each mortgage discount point paid at a price of 1% of the mortgage loan reduces the mortgage interest rate by 0.25%. Over the course of a 30-year mortgage, this can amount to a huge overall savings.
Using a sample mortgage of $250,000 with a 5% mortgage loan interest rate, (without any points paid) the total interest paid over the life of the loan amounts to $233,139. The same mortgage loan with one point paid (for a cost of $2,500) has interest that amounts to $219,483. In other words, the $2,500 investment toward reducing mortgage loan interest resulted in a savings of $13,656, which minus the original investment amounts to $11,156. A no-brainer? Let's do the math.
The reality of the situation
The interest savings realized each month in the above mortgage situation with one point paid totals $37.93, meaning that it would take about 66 months, 5.5 years, to make back the initial $2,500 investment. The simplest (and somewhat flawed) assumption homeowners make is that if they plan to keep the same mortgage for at least the 5.5 year threshold, then paying points is a good investment.
In what seems like a feel-good gesture, the nation's largest mortgage originators like Wells Fargo (NYSE:WFC) and JPMorgan Chase (NYSE:JPM) provide homebuyers the option to pay points and in some cases even finance points as part of their mortgage amount. Here are a few reasons why the true payback may not be as grand as the math implies.
The first consideration is whether the homeowner has 1% of the home's value to pay points on the mortgage loan. If this money is tough to get and could result in other higher-interest loans, the decision not to pay points is fairly obvious. But let's assume the homeowner has an additional $2,500 available.
The biggest issue to consider is the opportunity cost of the $2,500 invested to pay down the mortgage loan interest rate. Consider two reasonable alternatives to how the same money may be spent. Option one would be to use the $2,500 as an additional down payment on the loan, option two would be to invest the $2,500 and yield a conservative 5% rate of return.
Using the $2,500 as an additional down payment would lower the monthly mortgage payment by $13.42, and extending the breakeven point from 5.5 years to 102 months, or 8.5 years. Beyond 8.5 years, paying points still may be the better investment, but homeowners unsure of how long they may reside in the home may be better off putting the money toward their down payment and gaining an immediate return on their investment.
Though small, the contribution toward reaching a 20% downpayment would also hypothetically lead to a quicker removal of the required Private Mortgage Insurance or PMI that lenders automatically place on mortgage loans in excess of 80% of the home's value.
Option two had the homeowner investing the $2,500 with an expected 5% yield. Over the 30-year life of the loan, the original investment would be worth $11,170, compared with the $13,656 saved in interest.
If the investment can yield 5.68% compounded monthly, the future value of the investment roughly equates to the interest savings from paying points. If the homeowner can earn a still reasonable 8% rate of return, that investment would be worth twice as much as the amount of interest saved by paying points.
Making the right choice
The break-even point cited by mortgage originators is a guideline at best, and makes the assumption that you can afford 1% of your mortgage loan amount and second, that you would otherwise not invest it wisely. While I hope the first condition is something you can meet, I hope the second is not. Ultimately, the right choice depends on your circumstances.
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Shamus Funk has no position in any stocks mentioned. The Motley Fool recommends Wells Fargo. The Motley Fool owns shares of JPMorgan Chase and Wells Fargo and has the following options: short June 2014 $50 calls on Wells Fargo and short June 2014 $48 puts on Wells Fargo. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.